401(k) plans can provide employees with before-tax contributions and free money from your employer. Were you aware of the match contributions (e.g. free money) and tax benefits offered from 401(k) company sponsored programs? Outlined below are the pros and cons of a 401(k) plan and whether if it is a good plan for you.
Why You Should Participate in Your Company’s 401(k) Plan
There are two primary advantages of participating in a 401(k) plan; tax benefits and free money from your employer. The tax benefits of a 401(k) plan are a reduction of pre-tax income and tax deferral of contributions made into the 401(k) plan.
When you contribute to a 401(k) plan that contribution is subtracted from your total gross income, which reduces your taxable income by the amount contributed to your 401(k). In 2021, the limit of this benefit is $19,500 in contributions or $26,000 if over the age of 50.
The second tax advantage of a 401(k) is that the when you make withdrawals on a 401(k), the withdrawal is taxed at the ordinary income tax rate, which is often lower than the tax rate during your working years. When retired, a large portion of your living expenses usually comes from retirement savings withdrawals, so there is very little ordinary income. Because of that, many people can expect some tax savings on the withdrawals as well.
Another advantage of a 401(k) is found in the employer match. Employers often offer a matching program for employee contributions to a 401(k). While the percentage amount of the match varies, it is free money offered by an employer that is not received by an employee unless it the 401(k).
There is a catch though. To get the full benefit of the employee match, a vesting period of generally a couple years accrues before the full value of the match becomes available to you.
Why You Shouldn’t Participate in a 401(k)
There are several reasons you shouldn’t participate in a 401(k). First, you have no real control over your investments in a 401(k), so if you like absolute control over your retirement savings, a 401(k) may not be right for you.
Secondly, if you are an employee who is not looking for a long-term employment situation, a 401(k) may not be best for you. This applies to those who are unsure of the overall stability of their job situation as well. If you change jobs before you reach your full vestment period, you do not receive the full value of the employer match. Also, when you leave a job, you have a short period of time to roll your 401(k) from your previous employer into an IRA, your new employer’s 401(k) plan, or cash out the 401(k) plan (which incurs a 10% tax penalty).
So Should you participate in your employer’s 401(k) plan?
401(k) plans tend to be a great way to enable you to save for retirement, while potentially picking up tax breaks and free money from your employer while you’re at it. Participation in a 401(k) may not be the right option if you are a short-term employee, or if your employer does not provide a matching program.